Gold prices: Another 'new normal'?

From being object of villainous affectation in action movies, gold has moved back to the centrestage of the real world.

Thanks to a massive purchase by the Reserve Bank of India worth over $6.7 billion — of IMF reserves — more central banks are rethinking US Treasury debt purchases.

Even the central bank of Sri Lanka has followed suit and begun to buy gold. All this comes at a time when there is a venerable tradition, at least since Keynes onwards, to dismiss gold as an irrational fascination and abnormal store of value.

On Monday, gold marched up to $1,137 per ounce. This comes at a time when China has doubled its reserves over the past five years; when India holds nearly 6 per cent of its foreign exchange ($200+ billion) in gold. And it isn't just gold.

These events coincide with the secular increase in commodity prices since early 2001. A nearly 20 year decline and stagnation of commodities ended in around early 2000s.

The end of this "great commodity deflation" can, in parts, be attributed on the demand side to the great Asian economic engines that have jump started — after centuries of sleep-walking. From 2001, gold prices have trebled to $1,121 an ounce in 2009.

Excessive

To many, this may seem like an excessive high. Yet, the irony is, to hit an all time high observed in 1980 — after adjusting for 2007 dollars — gold would have to be at $2,400.
 
That is, gold would have to more than double in order to exceed the all time high. That high came when the US economy was relatively less worse off. Predictably, contrasting views have naturally contested the viability of this proposition.

The co-founder of Quantum Fund and noted commodities bull Jim Rogers has said gold will exceed $2,000. In contrast, Nouriel Roubini has called such claims of $2,000 as "nonsensical" in absence of inflationary pressures.

It is increasingly agreed upon that the levels of gold prices observed even a few years ago — of lows in 800s are unlikely to be upon us in the coming 18-24 months. The market belief is that China has basically sold the rest of the world — "a Beijing put".

A put is a derivative instrument. A buyer of the put has the right, but not the obligation, to sell the underlying asset. In the present case, it seems, the rest of the world has the right to sell the asset, if it suspects prices are likely to decline.

However, the Chinese and Indian policymakers increasingly find themselves motivated by two eternal factors: Fear and greed. The fear that their massive hoardings in gold will lose value — resultantly, they'll end up buying systematically at market dips, or when leveraged positions are being unwound.

The greed from the fact that any further buying of US debt might decline due to dollar's depreciation — and resultantly, they want to invest in assets that increase in value. In essence, the Chinese and Indian policy has assured the world market that they will continue "to buy the dips" in prices.

Thus, the market is implicitly expecting a natural floor. This, perhaps, is one of the visible consequences of the "new normal" — a portentous phrase by Mohammad Al Erian of Pimco in California.

Structural fears

Any price appreciation, on the demand side, emerges through structural fears (from the sub-prime crisis), possibilities of deflation or inflation and macro-economic uncertainty.

There is also the supply side aspect. Since 2001, annual gold mining production has declined due increased regulatory issues and difficulties to set up mining operations.

Further, new asset structures (physically backed Exchange Traded Funds) are cropping up. Finally, when there is gold — there is always geopolitical uncertainty as a contributing factor.

Directly or indirectly, the war expenditure in Iraq and Afghanistan continues to hover in the background. Kautiliya, an Indian precursor to Machiavelli and Adam Smith, wrote in about 300 BC: "The army is sometimes the means of securing the wealth acquired; but wealth is always the means of securing both the treasury and the army."

American policymakers have taken to heart the first half; the Chinese have learnt the latter.

Such cognitive dissonance, also, lies at the heart of appreciating gold prices.

The columnist works for a major European investment bank in New York City. You can follow his tweets at http://www.twitter.com/ks1729